Cryptocurrency exchange operators must enter regulatory sandbox if they want to be licensed in Hong Kong

The city’s securities watchdog last week unveiled a new set of rules governing cryptocurrencies, which included a potential route for the licensing of digital asset exchanges for the first time.

Here’s what you need to know about the new regulations.

What happened?

The Securities and Futures Commission’s new rules on cryptocurrencies can essentially be boiled down to two points. Firstly, all funds that invest more than 10 per cent of their portfolios in crypto-assets will be licensed by the SFC one way or another, and are required to deal with institutional investors only. That is regardless of whether they invest in only bitcoin and ethereum, or other crypto-assets that fall under the definition of securities.

Secondly, if cryptocurrency exchanges want to be licensed and regulated by the SFC they should voluntarily put themselves in the regulatory sandbox, which among other things, requires them to only deal with institutional investors. After the exploratory stage ends, the SFC will then decide whether it is minded to license and regulate cryptocurrency exchanges. There is no specific timetable yet.

Why the change?

Currently no license is needed to operate a cryptocurrency exchange in Hong Kong. The SFC said it’s aware of the risks of investing in cryptocurrencies – including wild speculation, cyber thefts and frauds – but acknowledged that it does not have the legal authority to regulate things that are not “securities” or “futures contracts”. SFC CEO Ashley Alder said the new rules are a “creative framework which should bring a significant number of these activities [involving cryptocurrencies] into our regulatory net for the first time”.

What are the approaches in other jurisdictions?

Japan last year became the first country to regulate cryptocurrency exchanges. Its main financial regulator has granted licenses to 16 exchanges, but has turned more cautious after one of its exchanges suffered a US$530 million hack in January.

In the US, the New York State Department of Financial Services issues so-called “BitLicenses” for exchanges to operate. China has banned cryptocurrency trading outright.

So how can exchanges be licensed in Hong Kong?

First, they need to sign up for the sandbox under the prerequisite that they offer trading of at least one or more crypto-assets qualifying as securities – so as to fall into the SFC’s regime.

Then there are lots of boxes to tick. For example, exchanges are barred from dealing with retail investors, or offering leverage and margin trading. They are required to hold insurance for almost all funds they keep and maintain bank accounts in Hong Kong.

Who is qualified then?

No one – at least for now. For one thing, none of the major cryptocurrency exchanges operating in Hong Kong list security tokens. Most of them deal with retail investors, and don’t fulfil the SFC’s other requirements either.

Wait, what are security tokens?

The cryptocurrencies we are familiar with – such as bitcoin and ethereum – are usually regulated as commodities. Securities tokens, however, represent ownership in a real-world asset such as real estate or holdings in a fund, subject to regulations under security laws. So far there are only a handful of security tokens, both because the idea is relatively new and because compliance is difficult.

What’s the reaction so far?

While some welcomed the SFC’s move as a form of recognition of the cryptocurrency industry, others complained that the harsh sandbox regime for exchanges might drive them out of Hong Kong.

Leo Weese, president of the Bitcoin Association of Hong Kong, said the sandbox is “a cage that places unreasonable burdens on exchanges”.

“While Hong Kong was a better place when it did not bother such platforms, it was inevitable this day would come,” he wrote in an online post. “Exchanges will likely maintain parts of their teams in Hong Kong, but work harder to convince the public of a new narrative that places them outside the SAR.”

“We will approach the SFC to understand better what would be the requirements to get into that sandbox and then we will see whether it makes sense for us or not. So far, no plan to leave Hong Kong,” said Aurélien Menant, founder of cryptocurrency exchange Gatecoin.